Lack of volatility implications for NLY, AGNC

Mortgage-backed securities are the starting point for all mortgage market pricing, and they’re the investment of choice for mortgage REITs

When the Federal Reserve talks about buying mortgage-backed securities (MBS), it’s referring to the To-Be-Announced market (usually referred to as the TBA market). The TBA market allows loan originators to take individual loans and turn them into a homogeneous product that can be traded. TBAs settle once a month, and Fannie Mae loans are put into Fannie Mae securities. TBAs are broken out by coupon rate and settlement date. In the chart below, we’re looking at the Fannie Mae 4% coupon for September delivery. Followers of this weekly piece may notice that the coupon keeps changing. The 4% is known as a “cuspy coupon.” Because rates have risen, the current coupon Fannie Mae TBA is now 4%. We are close to making the transition to the 4.5% coupon.

The TBA market is the basis for which your loan originator prices a loan. When the originator offers a loan to you (as a borrower), your rate is par, give or take any points you’re paying. Your originator will then sell the loan into a TBA. If you’re quoted a 4% mortgage rate with no points, the lender will fund your loan and then sell it for the current TBA price. In this case, the TBA closed at 102 3/32, which means your lender will make 2% before taking into account the cost of making the loan.

The Fed is the biggest buyer of TBA paper. Other buyers include sovereign wealth funds, countries with trade surpluses with the United States, and pension funds. TBAs are a completely “upstairs” market in that they don’t trade on an exchange and most trading is done “on the wire,” or over the phone.

All about Friday’s jobs report

The pre-Labor day week was relatively dull and fixed income markets sold off ahead of Friday’s jobs report. The 10 year was actually trading above a 3% yield prior to the jobs report, but rallied on the disappointing report.

Implications for mortgage REITs

Mortgage REITs, such as Annaly (NLY), American Capital (AGNC), Capstead Mortgage (CMO), MFA Financial (MFA), and Hatteras Financial (HTS), are the biggest beneficiaries of quantitative easing, as quantitative easing helps keep REITs’ cost of funds low and they benefit from mark-to-market gains. This means their existing holdings of mortgage-backed securities are worth more as the TBA market rises. The downside is that interest margins compress going forward, because yield moves inversely with price. Also, as mortgage-backed securities rally, prepayments are likely to increase, which negatively affects mortgage REITs.

As a general rule, a lack of volatility is good for mortgage REITs because they hedge some of their interest rates risk. Increasing volatility in interest rates increases the cost of hedging. This is because as interest rates rise, the expected maturity of the bond increases, as there will be fewer prepayments. On the other hand, if interest rates fall, the maturity shortens due to higher prepayment risks. Mechanically, this means they must adjust their hedges and buy more protection when prices are high and sell more protection when prices are low. This “buy-high, sell-low” effect is called “negative convexity,” and it explains why Fannie Mae MBS yield so much more than Treasuries. While Fannie Mae mortgages don’t have an explicit government guarantee, they are “government-sponsored” and considered to be guaranteed by the government. That said, Ginnies and Fannies do trade at a spread to each other, with Ginnies trading at a premium because of their explicit government guarantee.

To help us personalize your experience, which of the following best describes you?

Financial Adviser

Investment Professional

Individual Investor

What is the approximate total amount of the assets under your advisement?

Less than $25 million

$25 million to $99 million

$100 million to $499 million

$500 million or greater

What is the approximate amount of your firm's total assets under management (AUM), if applicable?

Less than $25 million

$25 million to $249 million

$250 million to $999 million

$1 billion to $9.99 billion

$10 billion or more

Don't know

Not applicable

What is your total amount of investable assets?

Less than $25,000

$25,000 to $99,999

$100,000 to $249,999

$250,000 to $999,999

$1 million or greater

Prefer not to say

Thank you!

x

There are no shortcuts to investing.

But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.

We think so too.

There are no shortcuts to investing. But if everyone had access to the trade secrets the top 10% of hedge fund managers use, their retirement path to wealth would be clearer. Enter your email address to discover how in our Market Realist Chronicles newsletter. You’ll receive must-know market insights straight from our former hedge fund manager, who managed $1 billion and made $2,000 an hour in the market, and his team of unbiased professional analysts.

Customize your experience.

Complete your registration by adding a password and customizing your Market Realist experience. You’ll quickly create a watch list to track the stocks and ETFs that matter most to you and your portfolio.